Real estate investors who sell highly appreciated assets are often left with large capital gains tax liabilities. Reinvesting sale proceeds through a 1031 exchange is one way to defer those gains.
There are a few different ways to complete an exchange. You can purchase another like-kind asset, or buy the exact amount of shares you need in a Delaware Statutory Trust to satisfy exchange requirements. You also can reinvest the sale proceeds in a tenant in common (TIC) property. In this article we’ll take a closer look at TIC investment opportunities and how they fit in with 1031 exchanges.
What is a Tenant in Common Arrangement?
A tenancy in common, also known as a TIC, is a legal arrangement in which two or more parties have ownership interests in a real estate investment. Owners don’t have to have equal shares, which can be beneficial to 1031 exchange investors because they can purchase TIC shares in equal or greater amounts to satisfy their exchange requirements.
There are some specific guidelines set forth by the Internal Revenue Service for properties to be classified as tenants in common. These include:
- There can be no more than 35 total owners.
- TIC owners have the liberty to sell, transfer, or mortgage their shares independently from the other owners.
- All major operating decisions have to receive unanimous approval by all co-owners.
- TIC co-owners share in expenses and debt servicing according to their pro-rata shares in the property.
- Income distributions, when applicable, are disseminated according to each owners’ pro-rata share of the asset.
- Income generated from the property can only be distributed to titled co-owners.
- TIC sponsors cannot receive any compensation through asset income.
- Co-owners can have the right to bequeath their TIC shares to an heir of their choosing.
Tenant in Common, 1031 Exchanges, and Capital Gains Taxes
Investors seeking to defer capital gains taxes from the sale of investment properties can defer those gains by reinvesting the entirety of their sale proceeds in a tenant in common property.
TIC investment opportunities are usually pre-packaged by a TIC sponsor. Financing for the asset is often already secured, which can help investors meet the important exchange deadlines of identifying a replacement property within 45 days and closing on it within 180 days from the sale of the relinquished asset.
Since each owner has an undivided interest in the property, each TIC member is considered an individual taxpaying entity – that’s why purchasing shares of a TIC qualifies for 1031 exchange treatment.
Investors who want to sell their TIC interests face a different situation entirely. You can only defer capital gains taxes by reinvesting all your sale proceeds in a TIC or a like-kind asset, and the asset must be placed into service as an investment property. You can’t purchase shares of a tenant in common property and then live there. However, if you rent out the property for a minimum of two years and then use it as your principal residence for two of the last five years, you may qualify for a capital gains tax exemption. If you sell your TIC shares but never occupy the property, you likely will generate a taxable event stemming from the original asset that was part of your 1031 exchange.
The Bottom Line
Exchanges are a tax-deferral strategy that doesn’t eliminate any capital gains liabilities unless you bequeath the property (or TIC shares) to an heir upon your death. Then, the heir inherits the property at a stepped-up basis that can eliminate any rolled-over capital gains taxes.
Investors who purchased shares of a tenant in common property as part of a 1031 exchange may trigger a taxable event if they subsequently divest their TIC shares in a traditional sale. Consult with qualified accountancy or taxation professionals to discuss your particular situation well in advance of the disposition of your TIC investment to fully understand the tax implications.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
Because they are private placements, TICs are illiquid securities. There is no secondary market for TIC investments. Moreover, the form of ownership may require unanimous consent to sell a TIC interests.
Like any investment in real estate, if a TIC property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions.
TIC properties employ professional asset and property management, so while TIC co-owners vote on major issues, they do not have direct say over day-to-day property management situations.
All investments have an inherent level of risk. The value of your investment will fluctuate with the value of the underlying investments. You could receive back less than you initially invested and there is no guarantee that you will receive any income.